IFN - IFN Vs. INDY: Choosing The Best Fund To Navigate Through The Adani Affair

Summary

• The "Adani Affair" has raised some doubts about investing in Indian equities, namely because of the contagion effect.
• This thesis aims to clear these, namely through a comparison of the performances and holdings of two funds, Aberdeen's IFN and iShares' INDY.
• I am bullish on IFN as it has no direct exposure to Adani, while also providing a high level of income.
• This optimism is also supported by macroeconomic conditions in India.
• I also elaborate on the risks pertaining to India's sweet spot and the China Covid reopening deviating fund inflows from the subcontinent to East Asia.

During my last thesis on iShares S&P India Nifty Fifty Index ETF ( INDY ), I was optimistic about Indian equities which had also managed to outperform the mighty American S&P 500 comprising some of the world’s largest publicly listed companies.

However, the "Adani Affair" which started on January 24 this year together with the China Covid reopening seems to have changed investors' sentiment with INDY down by around 2% while the SPDR S&P 500 Trust ETF ( SPY ) has gained by 2.4% as shown in the table below. In contrast, the India Fund ( IFN ) by Aberdeen has delivered a positive performance which this thesis will analyze in view of exposure to the Adani group of companies.

Another objective is to assess how the two international equity ETFs will perform for the rest of this year by considering factors like inflation and the Indian economy, and this, at a time when the stock market stands to be impacted by slowdown risks as central bankers raise rates and increment borrowing costs.

The Adani Affair

This affair is named after the billionaire at the head of the Adani Group (as pictured below), one of the largest industrial conglomerates in the country, ever since the strong criticism of Hindenburg Research , which pertains to the valuation and the excessive level of indebtedness of the group. Hence, since related news was publicized at the end of last month, the group's combined capitalization has shrunk by more than 100 billion dollars with reports that Switzerland-based global investment bank and financial services firm Credit Suisse ( CS ) would no longer accept bonds linked to Adani's companies as collateral.

Pursuing further, according to Nikkei Asia, the Adani group's debt constitutes around 1.2% of the Indian economy, which is not significant. Also, according to Fitch Ratings , which is an international credit rating agency, Indian banks’ exposure to Adani’s assets does not by itself represent “substantial risk to the bank’s standalone risk profiles”.

Consequently, despite the Adani group itself suffering and likely to suffer more as it has to spend less capital for business expansion purposes and instead dedicate more to reimbursing debt, the outlook for other Indian stocks seems to remain intact. Still, as shown by the blue and orange charts below, on January 25 both ETFs' share prices were adversely impacted, implying that there has certainly been an adverse impact on the broader Indian equities as a result of the contagion effect.

Going into further details, while both have been impacted, there has been a difference in the performance of INDY and IFN with the latter (in orange) outperforming, which is partly explained by its holdings.

Comparing INDY's and IFN's Holdings

As seen in the list below, with 37.1% of its assets dedicated to the financial sector, INDY includes a lot of bank stocks. By comparison, IFN has only 28.7% exposure to banking and related companies. Thus, part of the reason for INDY's underperformance can be linked to its higher exposure to the financial sector which is normally in the line of fire when the indebtedness of large companies comes into the limelight.

Now, coming specifically to exposure to Adani’s assets , there is Adani Enterprises and Adani Ports which at 0.59% and 0.54% of INDY's weight (as highlighted in yellow in the table below) respectively make up an insignificant portion of assets. This makes for a combined weight of 1.14%, but, the fact that the ETF’s shares fell by nearly 2% between January 26 and 27 suggests that investors have been fearful that the adverse impact could continue to be felt further ahead. As a matter of fact, the ETF suffered by -0.82% on a year-to-date basis as per the above chart.

As for IFN, its shares have also been impacted during the volatility at the end of January, but, eventually recovered with the ETF delivering a year-to-date gain of 3.87%. This lower volatility can be explained by the fact that it does not hold any of Adani’s companies as shown below, and after an initial market overreaction after the "Adani Affair" surfaced, investors eventually weighed in the risks more objectively and again trusted the Aberdeen fund.

Comparing Performances and Dividends

On top, IFN's better performance can also be explained by the higher dividends it pays, namely with a four-year average yield of 17.14% as pictured below. Its current dividend distribution rate is 10.77% and it pays shareholders on a quarterly basis, which are two factors that make it particularly attractive to income seekers. On the other hand, it charges a relatively high expense ratio which, at above 1.30% exceeds INDY’s 0.89% by far.

Relativizing slightly, INDY also pays dividends and its rather limited exposure to the Adani group of companies does not warrant a bearish position. Also, as I elaborate in the next section, strength in the Indian economy should also constitute an underlying support.

Still, investors are warned that there could be further volatility in the ETF's share price just like when the group canceled the sales of $2.5 billion in new shares on January 31 which pushed stock prices down further.

On the other hand, I am bullish on IFN, which has been trading on a fluctuating path but has managed to stay around the $16 support level since May last year. The ETF could rise to the $18-$19 range, which it last visited in March 2022, by the end of this year, not only due to its limited direct exposure to Adani but also because of the resilience of the Indian economy and as geopolitical tensions between America and China escalates following the flight of a Chinese balloon over U.S. territory.

At the same time and adopting a more cautionary posture, there are surely those wondering how to proceed in an economic context where the Reserve Bank of India has raised rates six times in relatively quick succession to come to a total hike of 250 basis points, in turn, leading to a repo rate (Indian equivalent of Fed Fund rate) of 6.5%.

The Resilience of the Indian Economy, Valuations, and the Sweet Spot

In this case, what clearly differentiates the U.S. and India is the growth potential. On the one hand, there are risks of a recession in the U.S. with a soft landing being viewed as a silver lining, and on the other, is the 7% GDP growth expected for the Indian economy in 2023-2024 according to government forecasts. In addition, while still having to raise rates to tame rising inflation, the Indian government and the central bank have managed to avoid a surge in the consumer price index.

Thus, the bonus for investing in IFN would be justified by the resilience of the Indian economy, whose growth is more than the 3% delivered by Chinese GDP for 2022 as the East Asian country witnessed its weakest point since 1976, undermined by its zero covid policy.

Looking at valuations, with its price-to-earnings ratio of 21.28x above the category average value of 17.31x by more than 23%, IFN is considerably overvalued. Its P/E is also higher than China’s CSI 300 by about 50%. Now, this valuation premium, which, in addition to the Indian economy's growth potential is also justified by India's sweet spot between the U.S. and Russia, as the country trades with both.

Looking deeper, while the country is an ally to the U.S. and Japan in their effort to contain China, it also has good relationships with Russia which enables its crude oil refineries to benefit from cheap Russian oil which they can then sell at high market prices. Along the same lines, with the U.S. and China now embroiled in a tussle over balloons allegedly used for spying purposes, it is less likely for politicians in Washington to scrutinize the India-Russia relationship at this stage.

Concluding with Caution

The above factors should support IFN's performance throughout 2023 and justify my bullish instance on the fund. As for INDY, its 12.24% of exposure to energy sector stocks (as pictured below) deserves to be highlighted in view of Russia prioritizing the export of crude oil to friendly countries including India after cutting output. This means the guaranteed supply of oil for Indian refineries at a relatively lower cost than when purchasing on the open market.

However, any escalation of the Ukrainian conflict or improvement in the American-Chinese relationship could put into question India's sweet spot and induce volatility in oil stocks, again implying downside risks for INDY.

Therefore, by analyzing both ETFs' exposure to the Adani group of companies whose publicly listed companies should continue to exhibit volatility as they recalibrate their growth strategies, this thesis has shown that an investment in IFN makes more sense, which is also attractive for income seekers.

Finally, sticking to my cautionary tone, it is important to be realistic about downside risks as more news associated with the Adani Affair hits the market. In addition, similarly to July 2022 , the most important source of volatility for Indian equities could simply be investors dumping stocks as they allocate more money to China, this time as the reopening of the country after the Covid freeze gathers pace.

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